Marketplace Uncertainty Affects Venture Capital Funds

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DETROIT — With the economy taking a dive, many companies expect to take a hit. But that may not be the case for the state’s venture capital funds right now.

Scott Reilly, of Peninsula Capital Partners in Detroit, said with his fund’s interest in private equity, subordinated debt, convertible debentures and preferred and common equity for growth, he isn’t seeing a downturn in the market.

“One reason I believe we aren’t feeling it right now is because we are not in a fundraising stage,” Reilly said. “We go out once every third year and ask for money from investors, close the partnership, invest the money over the next 2 to 3 years, and then do it all over again. So I am not aware of what the fundraising market is like right now and I can’t imagine what it would be like to be in that situation. It would be very difficult. When there are times of uncertainty, there is a tendency to hold on to what you have.”

Reilly did say that deals have remained reasonably strong, but the quality has not been as good, with some beginning to slightly taper off. And a lot of deals that were in the marketplace have been pulled or the companies that were looking for capital have decided not to move forward because they have bigger battles to fight at home. He also said he has seen banks that have not been supporting the transactions or venture capital funds taking a dimmer view of the transaction because of the uncertainty.

Regarding long-term effect, Reilly isn’t sure many investors or venture capital funds have asked themselves about the future. “The answer, I guess, is really quite simple: There will be as much impact in the private equity world as there is on the general economy,” Reilly said. “I think everyone agrees that the economy was listing into recession anyway, but Sept. 11 just gave it a big old push and it is going to be deeper and presumably longer than it would have been.”

To the extent that the recession exists now on a national basis — and if that extends for three years — there is no question that the private equity sector will suffer in terms of the amount of money made available by the traditional funding sources.

That’s why the effects of the terrorism attacks may not be felt immediately. All institutional investors have investment allocation plans, which designate a certain percentage of their total assets into various areas, such as common stocks, bonds, money market securities, real estate, natural resources and private equity. Within private equity there is a whole spectrum of investments, including buyout funds, venture funds, mezzanine funds, distressed debt funds, etc.

Each investor’s plan allocates somewhere on the order of 2 percent to 15 percent of its assets to investments and private partnerships like Peninsula Capital Partners. The plan is adhered to and assessed annually in terms of its appropriateness in the marketplace. But Reilly said most plans are “tweaked” once every few weeks or so.

“These plans are basically the bulwark of modern portfolio theory. You decide what the mission is of this investment pool and then a plan is made to fit that mission,” he said. “If we have a really bad recession where the economy really shrinks in every aspect of the market, then the public and the bond market will all feel that, which means the value of these portfolios will shrink.”

This is where what Reilly called the “shrinking pie syndrome” comes into play. In essence, the pie — or amount of total assets an investor has — shrinks because of a downturn in the market. For instance, 15 percent of a $4 billion investor’s pie may become 15 percent of a $3 billion pie. A smaller piece of pie is then what many venture capital funds are competing for.

With all of the doom and gloom of the current situation, Reilly is still optimistic for 2002. He even believes it will be a decent year, provided two things happen. First, banks can’t turn tail and run. “If the commercial lenders in America pitch their tents and go home, that will make a bad situation much worse.”

Secondly, sellers of corporate entities must adjust their valuations to the new paradigms of the marketplace, to something that is more realistic. “I am highly optimistic that will happen. It takes the sellers a quarter or two to catch up,” said Reilly. “They need to see some broken auctions, they need to see that no one will buy their company for six times its worth. They need to hear it from their friends at the country club. They need to hear it, observe it and believe that their company is worth less money, and then they will start selling their companies again.”

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